A Cure for Bloated CEO Pay

Business owners usually don't like it when their employees steal from them. For this reason is it is hard to understand why shareholders aren’t furious about the bloated paychecks their CEOs pocket every year.

The point here is a simple one: CEOs and other top executives are being paid far more than necessary to get people of comparable skill to do this work. We know this because the pay for top executives at companies that are every bit as large and profitable in Europe and Asia is typically 70% to 80% less than pay in the United States.

When a major company like General Electric GE 0.26% or Boeing sees manufacturing workers getting far lower wages in Mexico or China, it’s easy to see why they would tell their workers to take pay cuts if they want to keep their jobs. Companies don’t show the same resolve in reducing costs when it comes to the pay of CEOs.

The median pay for CEOs at large U.S. corporations rose 9% to $13.9 million in 2013. By comparison, the CEO of Toyota pocketed just $1.9 million in 2012. The head of Swedbank, one of the largest banks in Scandinavia, took home just $1.1 million in 2012. Suppose that by shopping around the world for top talent, U.S. corporations could get away with paying their CEOs $3 million a year. But since they didn’t, the top 200 largest companies were effectively ripped off by their CEOs for more than $2 billion last year. That doesn’t even count the excessive payments to other top executives who share some of the benefits of CEO-pay bloat.

The reason for excessive CEO pay at large corporations should be obvious to serious conservative critics of government. It is a problem of collective action. Just as many conservatives are wary of governments being captured by insiders and special interest groups, large corporations are also susceptible to the same sort of capture. In principle, corporate boards are supposed to act as agents of shareholders, making sure that top management acts to serve them rather than lining their pockets at their expense.

As a practical matter, directors are typically part of the insiders’ clique. They get very nice six-figure stipends to keep their mouths shut and go along. If directors were doing their job they would constantly be asking if it would be possible to find a CEO of the same caliber at a European or Asian company who would accept much lower pay. My guess is this conversation rarely takes place in corporate boardrooms.

There is a way to change the incentives for corporate boards; it’s called “Directors’ Roulette.” This little game takes advantage of the “Say on Pay” provision that was included in the Dodd-Frank financial reform bill. This provision requires companies to put the pay package for their CEOs to a non-binding vote of shareholders. Say on Pay allows shareholders to at least indicate they don’t approve of the money being diverted to the CEO.

Directors’ Roulette puts some teeth into this provision. It would deny directors their compensation if the CEO pay package they had approved was voted down by the shareholders in a Say on Pay vote. This sort of provision would provide a powerful incentive to directors to take their responsibilities to shareholders seriously.

If this seems harsh, it’s worth noting that shareholders very rarely vote down CEO compensation packages. Thus far, less than 3% of CEO pay packages have been lost in a Say on Pay vote. No one is going to frivolously go through the effort of organizing among shareholders to vote down a CEO pay package. In order for an investor or group of investors to spend the necessary time organizing, and for the effort to succeed, the overpayment must really be egregious. In such cases, it is difficult to imagine what the directors can claim they did to warrant paychecks of $150,000, $250,000 and possibly more.

The other nice feature of the Director Roulette system is that it doesn’t have to be implemented by legislation. Shareholders can demand their directors put such a provision into effect as a step toward greater accountability. While directors will not be anxious to put their own pay on the chopping block, how many of them really want to argue that they are worried about performing among the bottom 3% of all corporate directors? In most other lines of work, those in the bottom 3% get fired. Why would we exempt corporate boardrooms from the sort of accountability that is the norm elsewhere in the economy?

The trick to stopping CEOs from ripping off shareholders is to get the incentives right. Directors Roulette is a huge step in this direction.